In Depth: The Local Government Debt Crisis That Just Won’t Go Away (Part 2)

Editor’s note: Local government debt, in particular the trillions of yuan of liabilities hidden in financing vehicles, is threatening to overwhelm dozens of authorities across the country. In the second of this two-part series, we look at how policymakers, banks and officials are trying to find a way out. To read Part 1, click here.

Zhenjiang’s debt predicament is by no means unique. Yet the city has become the focus of policymakers’ attention as they try to ease the pressure on indebted local governments and clarify responsibilities for the borrowings of their financing vehicles.

The problem has taken on added urgency as 2019 marks the beginning of a three-year peak debt repayment period for local government financing vehicles (LGFVs), whose fundraising has spanned a wide range of channels including bond sales, bank and trust-company loans, and asset management plans sold by financial institutions. In addition to its domestic liabilities, Jiangsu Hanrui Investment Holding Co. Ltd., one of Zhenjiang’s top five vehicles, has a $300 million offshore bond maturing in June.

The Ministry of Finance (MOF), banking regulators, and city and provincial officials have been working for months to hammer out a plan for Zhenjiang. The outcome is being closely watched for signs of what policymakers will be prepared to accept in the hunt for a solution for dealing with hidden liabilities, and could offer a template for other local governments, LGFVs and their creditors.

“Zhenjiang’s debt-to-GDP ratio is pretty high and it started dealing with the problem quite early so it’s become a kind of bellwether for how (local government) debt is going to be tackled,” said Liu Yu, an analyst with Guosheng Securities who has analyzed Zhenjiang’s finances. “Other cities may be closely watching progress in Zhenjiang’s (plan). Once the Zhenjiang plan is confirmed, it could open the door for other cities to follow suit.”

Zhenjiang’s LGFVs borrowed billions of yuan for public welfare, infrastructure and poorly conceived projects that have long payback periods or can’t generate the money needed to repay the loans. But given its precarious fiscal position, Zhenjiang has few resources to come to their rescue and went cap in hand to higher authorities for help.

Under an agreement with the MOF last year, Zhenjiang was supposed to reduce government expenditure and sell off assets as the first step toward repaying its debts. Only then would it receive financial support from the provincial government and other sources of funding, a source close to the ministry told Caixin.

Questionable asset values

But offloading assets is easier said than done. Local officials are a long way from being in a position to start selling — they have yet to finish compiling a list of what the city and its LGFVs own, valuing the assets and verifying their ownership.

“There are billions of yuan of debt but the value of the assets they built is questionable,” a source with access to the city’s asset appraisal reports told Caixin. State-of-the-art government offices that cost tens of billions of yuan to build have an estimated value of just several billion yuan, he said, raising doubts about just how much money Zhenjiang could raise in the event of a fire sale of assets.

Meanwhile, local officials were pursuing other avenues to escape their black hole. Every year, provincial governments are given a quota for sales of special purpose bonds that they then parcel out to lower-level authorities. Last year, Zhenjiang received 14 billion yuan. This year it’s asking for 36.39 billion yuan (link in Chinese), more than its entire outstanding stock of such bonds at the end of 2018.

They also hatched a plan with the local branch of the China Development Bank (CDB), a policy bank that’s been heavily involved in LGFV financing via lending for the national shantytown redevelopment program, rural development and transportation infrastructure. There is speculation that the lender could become one of the main vehicles in LGFV bailouts, leading a program to swap their short-term high-interest debts into long-term loans with lower interest rates.

CDB has been eager to get involved in the swap program partly because it needs to find new lending projects as the shantytown redevelopment program tapers off amid criticism that it fueled property bubbles in small cities and added to local governments’ debt burden. The bank also has a stake in refinancing LGFVs’ debt to delay a rise in its exposure to credit risks given that it has lent heavily to some of the platforms through special construction funds, which were launched by the government in 2015.

Although there was no official disclosure of Zhenjiang’s debt workout, a brokerage report cited a Zhenjiang LGFV executive interviewed in mid-January as saying that it involved CDB providing special long-term loans of as much as 20 billion yuan at low interest rates to an asset management company (AMC) wholly owned by the Zhenjiang government. The AMC would then lend the money on to the city’s LGFVs.

Expectations that Zhenjiang was about to get a credit lifeline reconfirmed the market’s belief that local governments would do whatever it takes to repay LGFV debts, a phenomenon the central bank has referred to as “government creditworthiness illusion.” That led to a sharp drop in the financing costs of the city’s LGFVs. The coupon rate on a sale of 270-day commercial paper in March by Jiangsu Hanrui was just 4.8%, down from 6.3% on a similar note issued in January and 7.5% in November.

But the euphoria over the deal was short-lived when it emerged that the deal had not been approved by the MOF or the bank’s headquarters.

Passing the buck

A source with CDB in Beijing told Caixin that the plan had been put together by its local branch and that as it conflicted with the policies of the China Banking and Insurance Regulatory Commission (CBIRC), it couldn’t be approved without the go-ahead from regulators. He speculated that the finance bureau of local government may also have wanted to float the idea with the central government.

But a source close to the MOF said the proposal to swap Zhenjiang’s high-cost debt for long-term, low-interest rate loans, which ultimately come from the central bank, was essentially a bailout plan that would “just pass the high risks to the financial sector from the fiscal system.

“This would, in essence, just be creating a new financing vehicle for lending to Zhenjiang,” he said.

CDB has been involved in efforts by other provinces to deal with the hidden debts of their local governments but so far only one, in Shanxi, has gained head-office approval, the source with the bank’s headquarters told Caixin.

Shanxi, a coal-rich province in northern China that’s been hit hard by the decline of heavy industry, took a key step forward in its efforts to deal with local government debt in 2017 when it set up a state-owned enterprise (SOE), Shanxi Transportation Holdings Group Co. Ltd., to take over LGFVs in the highways sector and consolidate their assets and liabilities. The deal basically shifted the debt repayment obligations from the local government to a commercial business responsible for its own profits and losses.

Last year, the company renegotiated its debt and took out a syndicated loan of 260.7 billion yuan with seven financial institutions led by the CDB’s provincial branch. The loan carried a lower interest rate and extended the maturity of the debt to 20-25 years.

Zhejiang province in eastern China is also moving to tackle the LGFV hidden debt problem. Last year it consolidated its LGFVs, closing down those with no cash flow and transforming the rest into SOEs. Although the surviving firms were required to make public declarations that they would no longer raise funds for the government, Zhejiang earmarked 5 billion yuan to set up a provincial guarantee fund to them.

But none of these solutions actually decrease the stock of outstanding debt — they only lengthen the maturity of the borrowings and cut the interest costs rather than tackling the problem of how and whether they will ultimately be repaid.

Lasting solution

Some of the fundamental causes of the debt buildup in the first place — requirements on local governments to carry out infrastructure spending to bolster economic growth, investment in projects that are not commercially viable, constraints on local government finances and explicit borrowing, and unaccountable government officials who champion spending to win promotion — remain in place, making it even more difficult to find a lasting solution, analysts and government officials have told Caixin.

Policymakers and regulators have yet to agree on the way out for local governments. Concerned about the continuing moral hazard embedded in the system, the MOF is reported to be reluctant to allow another round of bond swaps to convert the hidden debt into explicit liabilities that sit on the books of local governments.

“Debt swaps would ramp up total government debt, which could shake market confidence in China and exacerbate the moral hazard of local governments continuing unchecked and risky off-balance-sheet financings,” S&P said in a report in October 2018.

The MOF is also cool on the idea. “The moral hazard is too great,” a source with the ministry told Caixin. He said it would create “endless trouble” if a new round of debt swaps was introduced to bring the hidden debt of local governments onto their books. Turning implicit debt into explicit debt would send China’s government debt ratio way above the international warning line, he said. Although he didn’t elaborate, he was likely referring to the European Union’s Maastricht Treaty, which set a limit on government debt at 60% of GDP.

The ministry’s original preferences were, among other things, to order banks to renew LGFV loans without first paying back the original debt, reduce interest payments or suspend the calculation of rate increases on unpaid liabilities, and grant the vehicles new loans to help them repay maturing bonds or trust loans. It also wanted financial institutions to swap the platforms’ maturing debt for equity. But financial regulators have resisted and the CBIRC made it clear to the MOF that they would not agree, sources have told Caixin.

The People’s Bank of China’s latest Financial Stability Report paints a frightening picture of the exposure of the country’s banking sector to LGFVs. Its preferred solution does not involve the banks directly, but puts the onus firmly on the fiscal authorities.

The report calls for a series of measures to be taken including opening “the front gate for local governments to borrow legally,” redrawing the fiscal relationship between central and local governments, imposing constraints on local government budgets and deemphasizing the “GDP-oriented performance review system” that has fueled the buildup of debt. It also urges local governments to stop interfering in financial regulations.

Political achievements

Sources close to the financial regulators have told Caixin that local authorities must be held accountable during the debt reduction process to guard against moral hazard.

“The main cause of the outstanding problem of off-the-books local government debt is the incorrect view on political achievements of government and party leaders in some places,” a source close to the CBIRC told Caixin. Local officials didn’t accurately calculate the risks and the costs against the benefits these projects would bring to people’s lives, “nor did they seriously vet spending on infrastructure projects or ensure the programs were funded in the ways required (by regulators),” he said.

Indeed, there are many in Zhenjiang who blame the city’s problems partly on the lack of proper long-term planning due to the high turnover of local leaders — Zhenjiang has had four different party secretaries over the past seven years.

“We often joke that Zhenjiang is just a training ground for vice provincial governors,” one local financier told Caixin. For example, Zhang Jinghua, Zhenjiang’s party secretary for about one year from April 2012, was promoted to become the secretary general of the provincial government in March 2013 and in 2016 was promoted to be Jiangsu’s vice governor. He is now party secretary of Nanjing, the province’s capital.

There are also calls for stricter scrutiny of how funds are used at the local government level.

“The key is … whether the money is spent on what is most urgently needed by the local economy and the people, whether the investment will yield a return, and whether it will generate cash flow,” a source close to a local branch of the central bank said. “Local governments must be punished severely if they spend money on white elephant projects.”

The source close to the MOF agreed that holding local governments accountable is critical. “The whole exercise is meaningless if we just play pass-the-parcel with the risks,” he said.

To learn more about how the city of Zhenjiang became the poster child for China’s local government debt crisis, check out Part 1 of the story.

Contact reporter Fran Wang (fangwang@caixin.com)